California Suplus Pits Investors, Democratic Spenders

By Michael B. Marois -
Jan 9, 2014

California Governor Jerry Brown
piloted the world’s 10th largest economy from a $26 billion
deficit to the biggest surplus in more than a decade. Now the
Democrat, who may seek a fourth term this year, is walking into
a fight over what to do with the cash.

Astrid Campos, a community organizer in Los Angeles, wants
the 75-year-old governor to spend some of California’s $5.6
billion projected surplus restoring health and welfare programs
cut in the recession. Tom Metzold, co-director of munis at Eaton
Vance in Boston, says the money should be stashed away for a
rainy day and to help extend the biggest rally since 1999.

Brown is scheduled to announce his plans today for what’s
likely to be one of the biggest surpluses in California history.
It’s a turnaround for a state once seen as ungovernable, facing
budget gaps that exceeded $100 billion combined, and forced to
issue IOUs to pay bills while lawmakers squabbled over how to
erase the shortfalls.

“We are going to have to fight the governor in order to
get any type of reinvestment,” Campos said by telephone. “It’s
a moral question. You can reinvest in these programs. You can
start to pay down debt and also have a healthy reserve. But
paying down debt and having a healthy reserve shouldn’t be
prioritized over families.”

California has seen its fiscal health improve with higher
income- and sales-tax levies sought by Brown and approved by
voters in 2012, better than-expected capital-gains tax revenue
from profits in stocks and spending restraint urged by Brown
last year. Three years after he took office, the state’s credit
rating is at the highest level since 2006 and its borrowing
costs at the lowest in more five years.

Rating Companies

The budget will spend $106.8 billion from the general fund,
the most ever, the Sacramento Bee reported yesterday, citing a
copy of the plan. Brown would boost spending on welfare, schools
and health care for the poor, while plowing $1.6 billion in
reserve and repaying $11 billion of budget debt. Brown spokesman
Evan Westrup declined to comment on the budget before its
official release.

Investors and credit rating companies are watching to see
whether Democrats use the money to prepare the biggest issuer of
municipal bonds to better weather future downturns.

The Democrats have their eyes on spending for new programs.
The last time the state was projected to have a multi-billion
budget surplus was in the fiscal year that started in July 2005,
according to the nonpartisan Legislative Analyst’s Office.

Senate President Pro Tem Darrell Steinberg, a Democrat from
Sacramento, wants to expand transitional kindergarten to 350,000
children as young as 4 years old, at a cost of almost $1 billion
annually by 2020. The money would hire an additional 8,000
teachers.

‘Spend It’

“It is the nature of politics that when there is extra
money, politicians will spend it,” said Metzold, based in
Boston for Eaton Vance Management, which oversees about $28
billion of city and state debt. “When there isn’t enough money,
they cut to balance and we tend to let the pendulum swing too
far in each direction.”

Brown persuaded voters in November 2012 to pass the highest
statewide sales tax in the U.S. and raised levies on income
starting at $250,000.

The surplus is projected to swell to $9.6 billion in five
years, when the temporary income- and sales-tax increases
expire. If the state fails to put away money, it could again
find itself mired in deficits when the economy falters.

“The perception of the state’s fiscal recovery is getting
ahead of the reality of the state’s fiscal recovery,” Gabe Petek, an analyst at in San Francisco for Standard & Poor’s,
said in a telephone interview.

Build Reserves

The budget cited by the Bee appears to endorse a plan by
Assembly Speaker John Perez, of Los Angeles, who is pushing for
a voter referendum in November that would require the state to
funnel surplus revenue from capital-gains taxes into a reserve
fund to avert cuts when the economy sags.

California gets 61 percent of its general-fund revenue from
personal-income taxes, with about 15 percent of that from
capital-gains levies. If approved, Perez’s ballot measure would
change the constitution to require the state to set aside excess
funds when revenue from capital gains exceeds 6.5 percent of
projections.

Once the reserve tops 10 percent of general-fund spending,
which pays for most basic services -- about $97.8 billion in the
fiscal year that ends in June -- the excess could be spent on
one-time needs, such as reducing debt, he said.

“We really want to avoid the mistakes we made in the
past,” said John Vigna, a spokesman for Perez.

Perez’s rainy-day fund proposal would replace one already
on the ballot. That plan, favored by Republicans and opposed by
public-employee unions, would fill the reserve whenever all tax
revenue exceeds 3 percent of general-fund spending. Democrats
can alter the ballot measure using their two-thirds majority.

Budget Progress

Brown has made progress in easing California’s year-over-year budget shortages. Last fiscal year, the state chipped $7.3
billion from what the governor called a “wall of debt,” or
recurring borrowing used in the past to plug deficits. The
current budget calls for paying off about 30 percent of the
remainder by the end of June.

The turnaround led Standard & Poor’s last January to raise
California’s credit rating to A, its sixth-highest level. It was
the first time it lifted the state since 2006. Fitch Ratings
followed in August with a boost to A, the state’s highest score
from Fitch since 2009.

The improved fiscal outlook and the demand for bonds to
shield income from California taxes has allowed the state’s debt
costs to tumble this year.

Winning Streak

Investors demanded as little as 0.3 percentage point of
extra yield to buy California debt instead of benchmark munis in
October, the least since 2008, data compiled by Bloomberg show.
The state’s bonds beat the $3.7 trillion local-debt market for a
fourth straight year, the longest streak since 1999, S&P data
show. While the whole market has lost 2.6 percent last year,
California debt was down 1.8 percent.

“I think we are more likely to see upgrades in California
than downgrades,” said Nicholos Venditti, an assistant
portfolio manager at Santa Fe, New Mexico-based Thornburg
Investment Management, Inc., which manages about $9.5 billion of
municipal debt. “But regardless of which way the rating moves,
the state will continue to trade at very tight levels.”